1. Copyright © 2012 McGraw-Hill Ryerson Limited 8-1 PowerPoint Author: Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance MANAGERIAL ACCOUNTING Ninth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB, LIBBY Variable Costing: A Tool for Management Chapter 8

2. 8-2 Copyright © 2012 McGraw-Hill Ryerson Limited Overview of Absorption and Variable Costing Direct Materials Direct Labour Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs Product Costs Period Costs LO 1

3. 8-3 Copyright © 2012 McGraw-Hill Ryerson Limited Quick Check Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends... Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends... LO 1

4. 8-4 Copyright © 2012 McGraw-Hill Ryerson Limited Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends... Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends... Quick Check LO 1

5. 8-5 Copyright © 2012 McGraw-Hill Ryerson Limited Harvey Company produces a single product with the following information available: Unit Cost Computations LO 1

6. 8-6 Copyright © 2012 McGraw-Hill Ryerson Limited Unit product cost is determined as follows: Under absorption costing, selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred. Unit Cost Computations LO 1

7. 8-7 Copyright © 2012 McGraw-Hill Ryerson Limited Income Comparison of Absorption and Variable Costing Let’s assume the following additional information for Harvey Company.  20,000 units were sold during the year at a price of $30 each.  There were no units in beginning inventory. Now, let’s compute net operating income using both absorption and variable costing. LO 2

8. 8-8 Copyright © 2012 McGraw-Hill Ryerson Limited Absorption Costing LO 2 Unit product cost. Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

9. 8-9 Copyright © 2012 McGraw-Hill Ryerson Limited Variable manufacturing costs only. All fixed manufacturing overhead is expensed. Variable Costing LO 2

10. 8-10 Copyright © 2012 McGraw-Hill Ryerson Limited Comparing the Two Methods LO 3

11. 8-11 Copyright © 2012 McGraw-Hill Ryerson Limited Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit We can reconcile the difference between absorption and variable income as follows: Comparing the Two Methods LO 3

12. 8-12 Copyright © 2012 McGraw-Hill Ryerson Limited Extended Comparisons of Income Data Harvey Company Year Two LO 3

13. 8-13 Copyright © 2012 McGraw-Hill Ryerson Limited Unit Cost Computations Since there was no change in the variable costs per unit, total fixed costs, or the number of units produced, the unit costs remain unchanged. LO 3

14. 8-14 Copyright © 2012 McGraw-Hill Ryerson Limited Absorption Costing These are the 25,000 units produced in the current period. LO 3

15. 8-15 Copyright © 2012 McGraw-Hill Ryerson Limited Variable Costing All fixed manufacturing overhead is expensed. Variable manufacturing costs only. LO 3

16. 8-16 Copyright © 2012 McGraw-Hill Ryerson Limited We can reconcile the difference between absorption and variable income as follows: Fixed mfg. Overhead $150,000 Units produced 25,000 units = = $6.00 per unit Comparing the Two Methods LO 3

17. 8-17 Copyright © 2012 McGraw-Hill Ryerson Limited Comparing the Two Methods LO 3

18. 8-18 Copyright © 2012 McGraw-Hill Ryerson Limited Summary of Key Insights LO 3

19. 8-19 Copyright © 2012 McGraw-Hill Ryerson Limited Effect of Changes in Production on Net Operating Income Let’s revise the Harvey Company example. In the previous example, 25,000 units were produced each year, but sales increased from 20,000 units in year one to 30,000 units in year two. In this revised example, production will differ each year while sales will remain constant. LO 3

20. 8-20 Copyright © 2012 McGraw-Hill Ryerson Limited Effect of Changes in Production Harvey Company Year One LO 3

21. 8-21 Copyright © 2012 McGraw-Hill Ryerson Limited Unit product cost is determined as follows: Unit Cost Computations for Year One Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less. LO 3

22. 8-22 Copyright © 2012 McGraw-Hill Ryerson Limited Absorption Costing: Year One LO 3 Unit product cost.

23. 8-23 Copyright © 2012 McGraw-Hill Ryerson Limited Variable Costing: Year One Variable manufacturing costs only. All fixed manufacturing overhead is expensed. LO 3

24. 8-24 Copyright © 2012 McGraw-Hill Ryerson Limited Effect of Changes in Production Harvey Company Year Two LO 3

25. 8-25 Copyright © 2012 McGraw-Hill Ryerson Limited Unit product cost is determined as follows: Unit Cost Computations for Year Two Since the number of units produced decreased in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is now higher. LO 3

26. 8-26 Copyright © 2012 McGraw-Hill Ryerson Limited Absorption Costing: Year Two These are the 20,000 units produced in the current period at the higher unit cost of $17.50 each. LO 3

27. 8-27 Copyright © 2012 McGraw-Hill Ryerson Limited Variable Costing: Year Two All fixed manufacturing overhead is expensed. Variable manufacturing costs only. LO 3

28. 8-28 Copyright © 2012 McGraw-Hill Ryerson Limited  Net operating income is not affected by changes in production using variable costing.  Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year. Conclusions Comparing the Two Methods LO 3

29. 8-29 Copyright © 2012 McGraw-Hill Ryerson Limited Explaining Changes in Net Operating Income Variable costing income is only affected by changes in unit sales. It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa. Absorption costing income is influenced by changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold. LO 3

30. 8-30 Copyright © 2012 McGraw-Hill Ryerson Limited Impact on the Manager Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions. These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are more consistent with managers’ expectations. LO 4

31. 8-31 Copyright © 2012 McGraw-Hill Ryerson Limited CVP Analysis, Decision Making and Absorption costing Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and keep-or-drop decisions. Produce positive net operating income even when the number of units sold is less than the breakeven point. Treating fixed manufacturing overhead as a variable cost can: Lead to faulty pricing decisions and keep-or-drop decisions. Produce positive net operating income even when the number of units sold is less than the breakeven point. LO 4

32. 8-32 Copyright © 2012 McGraw-Hill Ryerson Limited External Reporting and Income Taxes To conform to IFRS and GAAP requirements, absorption costing must be used for external financial reports in Canada. Either variable or absorption costing can be used when filing income tax returns. Since top executives are usually evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income. LO 4

33. 8-33 Copyright © 2012 McGraw-Hill Ryerson Limited Advantages of Variable Costing and the Contribution Approach Advantages Management finds it more useful. Consistent with CVP analysis. Net operating income is closer to net cash flow. Profit is not affected by changes in inventories. Consistent with standard costs and flexible budgeting. Impact of fixed costs on profits emphasized. Easier to estimate profitability of products and segments. LO 4

34. 8-34 Copyright © 2012 McGraw-Hill Ryerson Limited Variable Costing Variable versus Absorption Costing Absorption Costing Fixed manufacturing costs must be assigned to products to properly match revenues and costs. Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced. LO 4

35. 8-35 Copyright © 2012 McGraw-Hill Ryerson Limited Impact of Lean Production (JIT) Inventory Methods In a lean production (JIT) inventory system... Production tends to equal sales... So, the difference between variable and absorption income tends to disappear. LO 4

36. 8-36 Copyright © 2012 McGraw-Hill Ryerson Limited End of Chapter 8